What are security tokens?

Find out why security tokens are being called the next big thing, and where to buy and trade them.

If ICOs and utility tokens were the big cryptocurrency trend of 2017, then the scene is certainly set for security tokens to take centre stage in 2019.

Security tokens refer to financial securities, such as stocks, bonds and commodities whose ownership is attached to a crypto-token, hosted on a blockchain. Security tokens represent a more traditional type of asset than value-based cryptocurrencies or utility tokens and as such are sometimes referred to as digital assets, rather than cryptocurrencies.

Thanks to improved regulatory environments across the globe (particularly in the US) security tokens finally have the green light to enter the marketplace in a legal and compliant way like never before.

Below we explore security tokens in depth, we explain what makes them different to utility tokens, list which exchanges currently support them and take a look at how they work.

Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific
provider, service or offering. It is not a recommendation to trade.

What's in this guide?

What are security tokens?

Security tokens are revolutionary because they allow for securities such as stocks, bonds or derivatives, as well as commodities and real estate to be hosted on the blockchain in a tokenised format.

Before we go on though, it's important to understand what a security is. Securities traditionally refer to a very broad range of financial assets which can be traded on a regulated market. Common types of securities include stocks (shares), bonds, options and derivatives.

In the US, securities are classified depending on whether or not they pass the Howey Test. The Howey Test relies on four basic criteria, which are used to assess whether or not a financial product is a security. If a product conforms to these criteria, then it's likely to be defined as a security by the SEC:

People invest money into the product.

People are expecting profits from the investment.

The act of investing is a common enterprise – multiple people, or groups of people, can share in the investment.

Profits are dependent on the issuer of the investment, investment promoter or a third party, rather than the investors themselves.

However, because security tokens are a new and somewhat borderless asset class, they actually refer to much more than just the Howey Test's definition of a security.

As such, definitions of security tokens often include assets like commodities, real estate, physical property and art. Thus, it is important to know that security tokens can in fact refer to much more than just "securities".

What this all means is that the definition of a security token can vary, depending on where you are, who you ask and which country you're operating in.

As a general rule of thumb, security tokens are attached to either a real-world asset (like gold), rights to future profits (dividend payouts) or equity (shares in a company). Alternatively, a utility token entitles the holder to certain rights on a network.

Blockchain lawyer Michael Bacina discusses security tokens

It is important to remember that security tokens also include things outside the traditional world of finance, such as the DAO token which was attached to a purely crypto-economic investment and development fund operated solely by a blockchain. The DAO token entitled holders to dividends and voting rights, similar to shares in a traditional managed investment fund.

The DAO token was initially sold as a utility token through an ICO in 2016. However, it was retrospectively classified as a security by the SEC in the US in July 2017. The report which led to the ruling, known as "The DAO Report" has also been used to retrospectively classify several tokens as securities since it was published. The DAO Report, in conjunction with The Howey Test, can be considered as two very useful tools in determining whether a token is likely to be classified a security token within the US.

Like all new asset classes, security tokens have had their fair share of teething problems. As mentioned above, several existing tokens have been reclassified as securities since the release of The Dao Report and more are likely to follow. And of those tokens which are regarded as securities, not all were sold via compliant methods or registered with the SEC. Furthermore, not all exchanges that trade security tokens are permitted to do so, which is why our exchanges guide below only lists exchanges that are legally registered to trade securities.

Security tokens are still in their early stages, but their future is looking clear. They are increasingly being programmed to comply with local laws and regulations in line with the underlying security. Firms like Securitize and Neufund work with clients to launch tokens that are in strict compliance with local securities laws, wherever in the world that may be.

Programming a token with built-in compliance means that some tokens will only be able to trade hands between individuals and institutions that are legally allowed to possess them. Doing so helps avoid some of the situations outlined above. The ability to programme tokens in this way is just one of several advantages security tokens possess over legacy systems.

Furthermore, the emergence of highly specialised security token exchanges will provide a lot of much-needed clarification to traders, who are likely scratching their heads about which security tokens they can and can't trade. According to Securitize CEO Carlos Domingo "the exchange needs to onboard the investor" and then verify which markets the trader can participate in. This means that the onus will lie with the exchange, rather than the user, which makes for the smooth and familiar experience that cryptocurrency traders are familiar with.

Advantages of security tokens

So why are people so excited about security tokens?

Security tokens are regarded as revolutionary because they allow for assets to be traded on a blockchain, with all the advantages that confers. Let's have a look at some of the advantages security tokens offer, over traditional financial markets.

Blockchains are an immutable database of transactions which helps protect against fraud, malpractice and corruption. Furthermore, most blockchains keep a public ledger which is accessible by anyone, allowing anyone to audit the ledger.

While some blockchains are notoriously slow, others are tailored to financial markets and can process transactions at dazzling speeds. Furthermore, by using smart contracts, security tokens can automate the need for time-consuming tasks that normally require middlemen.

As mentioned, smart contracts can help eliminate menial tasks which slow things down. Better yet, they can be pre-programmed to deal with much of the legal requirements of securities, such as allowing for KYC, AML, regulatory requirements, legal interpretation and be programmed into the token, meaning only those who are allowed to use the security will be able to trade it.

Part of the blockchain revolution has been opening up financial markets to those who otherwise would not be able to participate. As a result, capital is able to flow in from places and people that it previously couldn't. Furthermore, digital asset markets operate 24/7 and aren't constrained by trading hours. The result is a more active and liquid market for securities and assets.

It's known that there is an 80–100 billion dollar inefficiency in the way that securities are traded today – Securitize CEO Carlos Domingo on why security tokens are better than legacy systems

Security token exchanges

With security tokens set to lead the next evolution of blockchain markets, exchanges are excited to join in on the action. As such, a number of existing cryptocurrency exchanges are exploring adding security tokens to their rosters, while in some cases totally new exchanges are being built to more closely comply with the regulation required to trade securities as well as cryptocurrencies.

Below we've collected a list of exchanges that currently support security tokens.

It's important to note that some exchanges may already be trading security tokens. However, it may also be the case that they are not legally allowed to in certain jurisdictions or that the exchange is hosting a security token without knowing it. As such, we have made sure to only list exchanges with explicit legal permission to trade securities in their given jurisdiction.

Lastly, decentralised exchanges are another place where you might be able to trade security tokens, although given their decentralised nature, it is up to the user to research whether trading securities on such an exchange is legal according to their country's laws.

Difference between security tokens and utility tokens

Unlike most things in blockchain, the difference between security and utility tokens is actually quite clear.

In short, a utility token gives you rights to operate and participate on a network.

Whereas a security token gives you rights of ownership or entitlement to an asset.

Let's expand on those a little bit.

As mentioned, a utility token gives the holder certain rights on a network, such as the ability to transact on Ethereum by paying gas fees in ETH or participate in voting on EOS by staking your tokens. On the peer-to-peer electricity trading platform, Power Ledger, users must first acquire and stake POWR tokens in order to buy or sell electricity on the network.

Utility tokens are usually issued via initial coin offerings (ICOs) in which buyers sign up and purchase utility tokens for an agreed-upon amount, which is usually less than US$1 per token. ICOs can be conducted in a number of ways, but one of the more common methods is to send cryptocurrency (usually ETH) to a smart-contract address. Once the token sale period is over, that smart contract then sends back the newly minted utility tokens in return.

Another way of issuing utility tokens is to airdrop them to existing cryptocurrency holders at random, in the anticipation users will take up the use of the associated network because they now own the token.

Security tokens on the other hand exist in a much more tightly regulated world than ICOs and airdrops.

As outlined above, a security token is a tokenised version of a real-world asset or security that can exist outside of the blockchain. This could be a share in an investment portfolio, a single Amazon stock or a gram of gold. Securities have strict laws which accompany their sale and trade, whereas assets are usually a bit more fluid.

Stephane De Baets of Elevated Returns discussing the Aspen Coin STO

For example, Aspen Coin gives holders shares in a real estate investment trust (REIT), which includes the St. Regis Aspen Resort. A share in a REIT is a type of security. In addition to ownership of shares, the coin also entitles holders to dividends paid out by the REIT.

The security token offering (STO) was conducted through Templum Markets, which is an SEC-registered trading platform. In the US, only accredited investors were allowed to participate, but outside the US anyone was allowed to join, provided they had the minimum amount of US$10,000 to participate.

STOs must abide by strict know-your-customer (KYC) and anti-money-laundering (AML) laws as well as a host of other legislation. While many ICOs now implement KYC and AML, this has not always been the case and airdrops circumvent this practice altogether.

As you can see, the difference between utility and security tokens is quite clear, both in terms of what it entitles the holder to, as well as how it is issued and used.

Security token offerings (STOs)

Along with a new type of token comes a new type of token offering. Security tokens are issued via STOs which involve more legal procedures than ICOs or airdrops. As such, several new platforms have been developed to help aid the legal issuance of STOs.

For instance the Polymath network uses a new token standard called the ST-20 which features built-in compliance, allowing users to issue security tokens in the US. Securitize and Harbor are two platforms which use the Ethereum blockchain to issue ERC-20 tokens with built-in compliance measures.

Then there is Neufund, a token issuance platform based in the EU, which has developed a hybrid model called the Equity Token Offering which looks to combine features of ICOs, IPOs and venture capital funding.

STOs are still a very new concept, so it is likely that their operation, legal status and availability will be subject to change over the coming months and years. Furthermore, because they focus on laws within a certain jurisdiction, eligibility to participate in STOs will vary on a case-by-case basis.

STOs vs ICOs

In the context of startup fundraising, STOs are becoming regarded as a more equitable way to raise capital than the previous ICO model.

This is because they give buyers an actual asset, such as a share of the company's equity, rather than a utility token which is technically decoupled from the success of the underlying company.

As a result, it is likely that in the future many companies will be under pressure to issue tokens via an STO instead of an ICO, when applicable.

This is because an STO leaves buyers with a security token, rather than a utility token which is dependent on network usage to gain value. If a company issues a utility token and then later makes profits in ways that are not connected to the utility token, then unfortunately, utility token holders have no rights to share in those profits.

Furthermore, ICOs are more vulnerable to exit scams because the company issuing the utility token has no shareholders to which they are accountable.

On the other hand, if a company issues security tokens via an STO, where the security token represents something like an equity share in the company, then the holders of the token are expected to share in that success through ownership of the token. Additionally, security tokens may even entitle the holder to payouts such as dividends.

However, it is important to remember that as outlined above, a security token can be almost anything tangible such as precious metals or property, so just because you are participating in an STO does not mean you are getting shares in a company.

This isn't to say that utility tokens are less valuable than security tokens. Rather they are two different products, with two different use-cases. The issue is that utility tokens have frequently been used to fill the role of security tokens, often leaving buyers with a product of questionable value and legality.

Now that regulatory bodies around the world have taken action on cryptocurrencies, information on whether a token is legally a utility or security is much clearer. As such, the way is now paved for security tokens to enter the market in accordance with local regulatory bodies, such as the Securities and Exchange Commission (SEC) in the US.

Therefore it is unlikely one type of token will dominate the other. Instead, companies looking to fundraise will now have the option of deciding which type of token best suits their product. Although it will still be up to savvy consumers to make sure they are getting the best deal, which will involve critical thinking about whether a security or utility token is best suited to the product.

Are security tokens legal?

The legal status of security tokens depends on the jurisdiction the token was created in and is being traded in.

Each jurisdiction has its own laws about what constitutes a security, who can issue securities, who can sell securities and who can buy securities.

In the US, security tokens and cryptocurrencies largely come under the remit of the SEC, which has been known to use the findings published in The DAO Report in assessing whether or not a token is a security.

In Australia the Australian Securities and Investments Commission (ASIC) is the federal body responsible for securities, whereas in Canada securities law is managed by the states and provinces, rather than federal government. Users in the UK may look to the Financial Services Authority (FSA) for guidance.Back to top

In a nutshell

Pros

Efficiency: A more efficient way to trade securities than using legacy systems.

Regulation: Subject to local laws and regulations which offer various levels of consumer protection.

Compliant: Regulatory compliance can be pre-programmed into the token.

Liquidity: Blockchain leads to more-democratic involvement in financial markets which is expected to increase liquidity in the long term.

In mid-2018 the SEC announced that Ether (the native token of the Ethereum blockchain) was not a security. It did note that tokens on top of Ethereum may be regarded as securities. Perhaps most importantly, the SEC added that it is possible for coins or tokens to change status depending on how they are operated.

Disclaimer: Cryptocurrencies are speculative, complex and involve significant risks – they are highly
volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of
future performance. Consider your own circumstances, and obtain your own advice, before relying on this information.
You should also verify the nature of any product or service (including its legal status and relevant regulatory
requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may
have holdings in the cryptocurrencies discussed.

James is a cryptocurrency writer for finder. He has a background in psychology and UX design which drives his interest in human behaviour, particularly the errors made when trying to navigate volatile marketplaces.

Disclaimer - Hive Empire Pty Ltd (trading as finder.com.au, ABN: 18 118 785 121) provides factual information, general advice and services on financial products as a Corporate Authorised Representative (432664) of Advice Evolution Pty Ltd AFSL 342880. Please refer to our FSG - Financial Products. We also provide general advice on credit products under our own Credit Licence ACL 385509. Please refer to our Credit Guide for more information. We can also provide you with general advice and factual information on about a range of other products, services and providers. We are also a Corporate Authorised Representative of Countrywide Tolstrup Financial Services Group Pty Ltd. ABN 51 586 953 292 AFSL 244436 for the provision of general insurance products. Please refer to our FSG - General Insurance. We hope that the information and general advice we can provide will help you make a more informed decision. We are not owned by any Bank or Insurer and we are not a product issuer or a credit provider. Although we cover a wide range of products, providers and services we don't cover every product, provider or service available in the market so there may be other options available to you. We also don't recommend specific products, services or providers. If you decide to apply for a product or service through our website you will be dealing directly with the provider of that product or service and not with us. We endeavour to ensure that the information on this site is current and accurate but you should confirm any information with the product or service provider and read the information they can provide. If you are unsure you should get independent advice before you apply for any product or commit to any plan. (c) 2018.

Thank you for your feedback.

Our goal is to create the best possible product, and your thoughts, ideas and suggestions play a major role in helping us identify opportunities to improve.

Important information about this website

finder.com.au is one of Australia's leading comparison websites. We compare from a wide set of major banks, insurers and product issuers.

finder.com.au has access to track details from the product issuers listed on our sites. Although we provide information on the products offered by a wide range of issuers, we don't cover every available product. You should consider whether the products featured on our site are appropriate for your needs and seek independent advice if you have any questions.

Products marked as 'Promoted' or "Advertisement" are prominently displayed either as a result of a commercial advertising arrangement or to highlight a particular product, provider or feature. Finder may receive remuneration from the Provider if you click on the related link, purchase or enquire about the product. Finder's decision to show a 'promoted' product is neither a recommendation that the product is appropriate for you nor an indication that the product is the best in its category. We encourage you to use the tools and information we provide to compare your options and find the best option for you.

The identification of a group of products, as 'Top' or 'Best' is a reflection of user preferences based on current website data. On a regular basis, analytics drive the creation of a list of popular products. Where these products are grouped, they appear in no particular order.

Where our site links to particular products or displays 'Go to site' buttons, we may receive a commission, referral fee or payment.

We try to take an open and transparent approach and provide a broad based comparison service. However, you should be aware that while we are an independently owned service, our comparison service does not include all providers or all products available in the market.

Some product issuers may provide products or offer services through multiple brands, associated companies or different labelling arrangements. This can make it difficult for consumers to compare alternatives or identify the companies behind the products. However, we aim to provide information to enable consumers to understand these issues.

Providing or obtaining an estimated insurance quote through us does not guarantee you can get the insurance. Acceptance by insurance companies is based on things like occupation, health and lifestyle. By providing you with the ability to apply for a credit card or loan we are not guaranteeing that your application will be approved. Your application for credit products is subject to the Provider's terms and conditions as well as their application and lending criteria.

Please read our website terms of use for more information about our services and our approach to privacy.